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APPENDIX 20A ASSET ALLOCATION

APPENDIX 20A ASSET ALLOCATION. OUTLINE Strategic Asset Allocation Tactical Asset Allocation Drifting Asset Allocation Balanced Asset Allocation Dynamic (Insured) Asset Allocation. STRATEGIC ASSET ALLOCATION INFORMAL APPROACH

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APPENDIX 20A ASSET ALLOCATION

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  1. APPENDIX 20A ASSET ALLOCATION

  2. OUTLINE • Strategic Asset Allocation • Tactical Asset Allocation • Drifting Asset Allocation • Balanced Asset Allocation • Dynamic (Insured) Asset Allocation

  3. STRATEGIC ASSET ALLOCATION INFORMAL APPROACH 1. SUBJECTIVELY ASSESS RISK TOLERANCE AS ‘LOW’, ‘MEDIUM’, OR ‘HIGH’. 2. DEFINE THE INVESTMENT HORIZON AS ‘SHORT’, ‘INTERMEDIATE’, OR ‘LONG’. 3. ESTABLISH THE OPTIMAL STRATEGIC ASSET ALLOCATION USING SOME ‘RULE OF THUMB’. FORMAL APPROACH 1. DEVELOP QUANTITATIVE FORECASTS OF E(R),  (R), AND S, B 2. DEFINE THE EFFICIENT FRONTIER 3. SPECIFY UTILITY INDIFFERENCE 4. CHOOSE THE OPTIMAL PORTFOLIO

  4. STRATEGIC ASSET ALLOCATION A: QUANTITATIVE FORECASTS B: EFFICIENT E(RP) FRONTIER EXPECTED STANDARD RETURN DEVIATIONSTOCKS 20.2% 18.0% STOCKSBONDS 13.0% 8.2% CORRELATION + 0.5 BONDSPC: UTILITY INDIFFFERENCE D: OPTIMAL PORTFOLIO (STRATEGIC CURVES ASSET ALLOCATION) E(RP) E(RP) I3 I2 I1X Y P P

  5. DRIFTING ASSET ALLOCATION • BUY AND HOLD POLICY. NO REBALANCING • PAYOFF 150 100 50 0 100 200 STOCK MARKET LEVEL • PORTFOLIO VALUE … LINEARLY RELATED TO THE STOCK MARKET • PORTFOLIO VALUE CAN’T FALL BELOW THE INITIAL INVESTMENT IN BONDS

  6. BALANCED ASSET ALLOCATION

  7. CONSTANT MIX POLICY

  8. DYNAMIC (OR INSURED) ASSET ALLOCATION SHIFTING THE ASSET MIX MECHANISTICALLY IN RESPONSE TO CHANGING MARKET CONDITIONS A CPPI POLICY TAKES THE FOLLOWING FORM: INVESTMENT = m PORTFOLIO - FLOORIN STOCKS VALUE m > 1 50 = 2 [100 - 75]

  9. PORTFOLIO COMPOSITION AND PAYOFFS FOR THE THREE POLICIES MARKET LEVEL IS 100 PORTFOLIO STOCKS BONDS TOTAL• BUY AND HOLD POLICY 50,000 50,000 100,000• CONSTANT MIX POLICY 50,000 50,000 100,000• CONSTANT PROPORTION • PORTFOLIO INSURANCE POLICY 50,000 50,000 100,000 MARKET LEVEL FALLS TO 80 PORTFOLIO PORTFOLIO (BEFORE RABALANCING) (AFTER REBALANCING) STOCKS BONDS TOTAL STOCKS BONDS TOTAL• BUY AND 40,000 50,000 90,000 40,000 50,000 90,000 POLICY• CONSTANT 40,000 50,000 90,000 45,000 45,000 90,000 MIX POLICY • CONSTANT 40,000 50,000 90,000 30,000 60,000 90,000 PROPORTION PORTFOLIO INSURANCE POLICY

  10. MARKET LEVEL RISES TO 100 PORTFOLIO PORTFOLIO (BEFORE RABALANCING) (AFTER REBALANCING) STOCKS BONDS TOTAL STOCKS BONDS TOTAL• BUY AND 50,000 50,000 100,000 50,000 50,000 100,000 POLICY• CONSTANT 56,250 45,000 101,250 50,625 50,625 101,000 MIX POLICY • CONSTANT 36,000 60,000 96,000 42,000 54,000 96,000 PROPORTION PORTFOLIO INSURANCE POLICY

  11. GRAPHICAL PICTURE PAYOFF CPPI POLICY BUY AND HOLD POLICY CONSTANT MIX POLICY STOCK MARKET LEVEL

  12. PERFORMANCE FEATURES DRIFTING ASSET ALLOCATION POLICY • STRAIGHT LINE PAYOFF• DOWNSIDE PROTECTION• MIDDLING PERFORMANCE BALANCED ASSET ALLOCATION POLICY • CONCAVE PAYOFF• SOME DOWNSIDE PROTECTION• DOES WELL IN FLAT, BUT FLUCTUATING, MARKETS CPPI POLICY • CONVEX PAYOFF• GOOD DOWNSIDE PROTECTION & PERFORMS WELL IN UP MARKET• DOES POORLY IN FLAT, BUT FLUCTUATING, MARKETS

  13. RISK TOLERANCE IN RESPONSE TO RECENT RETURNS RISK TOLERANCE D C B A RECENT RETURNS 100 S : 50 B : 50 S : 70 B : 50 A : TACTICAL S : 48 B : 72 (40 : 60) B : BALANCED S : 60 B : 60 (50 : 50) C : DRIFTING S : 70 B : 50 D : INSURED S : 80 B : 40 A : RISK TOLERANCE UNAFFECTED BY WEALTH CHANGES IF THE MARKET … PROSPECTIVE RETURNS MOVE TO A MORE DEF. POSTURE B : MILDLY SENSITIVE TO RECENT CHANGES IN WEALTH C : MORE SENSITIVE TO RECENT CHANGES IN WEALTH D : HIGHLY SENSITIVE TO RECENT CHANGES IN WEALTH

  14. RETURN AND COMFORT IN EFFECT, WE HAVE NATURAL CANDIDATES FOR PORTFOLIO INSURANCE, FOR A DRIFTING ASSET MIX, FOR SIMPLE REBALANCING TO A STATIC MIX, & FOR TACTICAL ASSET ALLOCATION. JUST AS PORTFOLIO INSURANCE IS NOT RIGHT FOR EVERYONE, THE SAME CAN BE SAID TACTICAL ASSET ALLOCATION. THIS HOLDS FOR THE SIMPLE REASON THAT AN IMPOVEMENT IN LONG-TERM RETURNS DOES NOT MEAN AN IMPROV’T IN THE “UTILITY” FOR ALL INVESTORS; UTILITY REFLECTS THE NATURAL HUMAN DESIRE FOR BOTH RETURN AND COMFORT. THE RETURNS FOR THE PATIENT, LONG-TERM INVESTOR, USING TACTICAL ASSET ALLOCATION, EXCEED THOSE OF THE REBALANCING INVESTOR, WHICH EXCEED THOSE OF THE DRIFTING MIX INVESTOR, WHICH EXCEED THOSE OF THE INSURANCE-ORIENTED INVESTOR. THE INVESTOR WITH THE PATIENCE & RISK-TOLERANCE TO FOLLOW A LESS-CONVENTIONAL & LESS-COMFERTABLE APPROACH EARNS REWARDS AT THE EXPENSE OF THE INVESTOR WITH THE SHORTER INVESTMENT HORIZON & AN INTOLERANCE FOR THE LOSSES THAT ACCOMPANY MARKET DELCINES. … WHEN WEALTH IS DECLINING, MOST INVESTORS SEEK THE SOLACE OF LOWER RISK, HENCE LOWER EXPOSURE TO RISKY MKTS … FEW INVESTORS RUSHED TO BUY STOCKS AFTER THE DISASTROWS 73 -74 BEAR MKT OR AFTER 1987 CRASH

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